Will ratings hinder reinsurer M&A and the hedge fund ‘play’?

In the investment banker ‘101’ playbook for cyclical industries the reinsurance industry has arrived at the page marked ‘weak pricing due to too much competition; sell M&A services to our clients’.

This, if you are a banker, can be a very nice place to be.  Less so of course for those clients that are the potential targets given that the ‘M’ in ‘M&A’ is rarely more than a fig leaf, but still there’s good money to be made advising the defenders.

Of course, an industry whose productive capacity is capital itself shouldn’t really be cyclical at all. There are no multi-year product development cycles, or billions locked up in factories, plant and machinery that have to be either ‘sweated’ or written-off.  A ‘rational’ reinsurance player can reduce volumes in a poorly priced market with an ease unheard of in most of business life.

Nonetheless cyclicality seems to prevail.

One could argue that since the current excess capacity is in part driven by the influx of ‘alternative capital’ what we are actually seeing is this driving a disruptive industry change to reduced pricing through a lower cost of capital rather than simply cyclical behaviour.

More generally, as Aon recently reported, there are ways for the traditional market to access that cheaper capital too.  If everybody’s capital gets cheaper then RoE targets should reduce (again meaning part of the pricing reductions could be structural not cyclical).

That said, few seem to actually believe that current pricing is sufficient.

So, for now at least, the mantra for many is ‘find more return’; either by consolidation, or pursuing more aggressive ‘hedge fund type’ investment strategies. Neither will be easily sold to the rating agencies.  Reinsurer M&A in a softening market has not always been a runaway success to put it mildly; the business case will not be easily made to the agency.

Increased market power can be a plus but it takes real scale in the reinsurance market for this to be much better than a neutral factor for a rating.

Cost efficiencies, if that’s the plan, are a positive of course but few reinsurer ratings are heavily influenced by this for the simple reason that – in a volatility based business – it’s management of that volatility (i.e. capital, underwriting and ERM) that drives the credit risk profile, not whether a reinsurer has rather overdone it in staffing up the marketing department.

Capital (rather than cost) efficiencies can work in the diversification sense; buying a well-established book is generally seen as less risky – reserve adequacy permitting – than organic diversification thanks to the avoidance of the anti-selection risk faced by new market entrants.

But if, one way or another, the plan involves a more aggressive use of the post-acquisition combined capital than that of the pre-acquisition acquirer, the conversation with the agency may not be straightforward.

Add to that the agencies’ inevitable concerns about execution risk and whether the acquired reserves are indeed adequate, and acquisitions at this point of the cycle (that are anything much more than ’bolt –ons’), can need some very persuasive logic to support the acquirer’s rating.

But what about ignoring the Banker’s siren calls and instead enhance returns via a hedge fund type investment strategy? Indeed this appears to being talked up as the industry trend ‘du jour’.

The logic is straightforward; while current reinsurance pricing limits healthy RoE’s the business still has the happy outcome of generating investable premiums up-front.  So, find a friendly hedge fund to spice up the investment strategy, focus on longer tail lines, and watch those enhanced returns roll-in.

Simple!

We are reminded of the 1980’s rhetoric of some Lloyd’s members’ agencies to prospective individual Names; “support your underwriting at Lloyd’s via a bank LOC based on your assets and  – shazaam – you magically get to use your capital twice!”.  The accompanying reality that, by doing so, the Name also had the privilege of risking their capital twice somehow seemed to get lost.

Not only was this ‘implied financial alchemy’ message successfully sold to non-experts, many industry participants fervently saw it that way themselves.

That seems bizarre with hindsight, but these things always do.

Yet a reinsurer actively pursuing a more aggressive investment strategy is doing exactly this; using and risking its capital twice.  And that is how the rating agencies will look at it.

More investment risk may or may not make sense in any given case but it is no generic solution to the problem of under-priced reinsurance.

To be fair, the expert asset management professionals involved will stress that it’s a lot, lot cleverer than that.  Asset/liability portfolio management can optimise the risk/return trade off and that’s the name of the game, but that’s a very hard trick to pull off in practice when a large part of that risk is derived from a soft reinsurance market.

Not that a case to the agency cannot be made, but demonstrating control of underwriting risk and pricing will, as ever, be crucial.  Writing for volume becomes a lot more enticing when the expected investment return goes up, and the agencies know that.

We recently read of one asset manager from a leading global firm who believes this trend will mean the agencies will have to adapt how they look at asset and liability risk when running their capital models on reinsurers.  Since the agency models have long factored investment exposures into their risk adjusted capital adequacy calculations we assume he means model changes would be needed to reflect the enhanced portfolio effect of ALM driven reinsurer investment strategies.

We suspect he will be disappointed. The last time the agencies allowed clever portfolio model analysis to mitigate the volatility of what were otherwise clearly high risk assets they ended up giving AAA ratings to pools of mortgages taken out by unemployed Americans.

And that, it seems reasonable to say, did not end well.

 

Stuart Shipperlee, Analytical Partner

 

Reinsurer downgrades on the cards for 2014; these may be very controversial

On the 20^th January, S&P announced that – for the first time since 2006 – it expects a negative trend in reinsurer ratings in 2014. Of the 23 groups (including ‘Lloyd’s) it defines as ‘global reinsurers’ it notes that ‘nearly half’ are materially exposed to the competition driven risks it sees as the likely primary cause of rating downgrades.

Anybody who has even casually scanned the industry media recently will not be surprised at S&P’s rationale.  Namely that excess capital (traditional or otherwise) and reduced demand are driving out ‘technical pricing’ discipline (we would add adverse development risk to those issues but the agency seems more sanguine).

So, why might reinsurer downgrades prove especially controversial?

Well, firstly, they often are.  Even some of those driven by what have seemed to be an unavoidably clear weakening of a reinsurer’s credit profile have been so, at least at the time (Converium, Gerling).  But also this time S&P is indicating the risk of downgrades driven simply by its view of a reinsurer’s prospective earnings.  It is one thing to issue a downgrade based on a balance sheet event such as a severe cat. loss, asset write-down or reserve hike, quite another when it’s based on the agency’s judgement about weakening earnings potential.

S&P notes that its concerns are about further price/terms & conditions weakness during 2014 as well as the rate reductions seen at the Jan 1 renewal.  So any earnings driven downgrades in 2014 could well happen before any published figurers from the reinsurer actually confirm such weakening.

This ‘prospectiveness’ is, of course, a prime focus of the agency’s revised rating criteria launched last May.

A fundamental plank of that is how the relative strength of a reinsurer’s ‘competitive position’ supports sustainably strong earnings and it is this – directly or indirectly – that S&P highlights as the likely source of downgrades.

While we wouldn’t disagree with the premise, in our view there are some anomalies in S&P’s take on this for the reinsurance industry.

Firstly, as we have highlighted before, the agency has had a surprisingly positive view of ‘competitive position’ across the ‘global reinsurance’ cohort.  Only one reinsurer (Maiden Re) is currently assigned a score for this of less than ‘Strong’ (‘Adequate’ in Maiden Re’s case).

For a famously cyclical, highly competitive business where ‘product differentiation’ is challenging to say the least this has always struck us as odd (although we presume that at least in part it’s a judgement relative to industries seen as more competitive still).

Secondly ratings are intended as ‘through the cycle’ views (indeed the agency’s focus on the importance of ‘competitive position’ reflects that).  So, what is it seeing that is not part of expected cyclicality?

Our take on both points is that the agency is unnerved by how reports (and maybe the non-public information it gets from rated companies) suggest that the industry’s claimed degree of focus on maintaining technical pricing appears to be about as resilient as the archetypal military battle plan (in that it has survived only up to the moment the ‘enemy’ of price-based competition has been engaged).

Prior to its announcement only one of the 23 groups had its rating on ‘negative outlook’ (again this is Maiden Re whose rating is BBB+).  Outlooks are the mechanism by which S&P normally flags a negative ‘trend’ (rather than a negative ‘event’) that may lead to a downgrade. The agency we believe is therefore now anticipating a significantly worse pricing environment than it expected just weeks ago.

So, whose rating is at risk?

No names are named in the announcement although  ‘smaller catastrophe-heavy reinsurers’ are highlighted as being under most pressure.

Ordinarily we would look to the ‘oulooks’ as a guide but, as above, the agency appears to have had a negative ‘step-change’ in its view that is not yet reflected in the outlooks.

Beyond Maiden Re’s ‘Adequate’ 14 of the 23 groups have the ‘Strong’ assessment for ‘competitive position’, 6 are assessed as ‘Very Strong’ and two as ‘Extremely Strong’.  A reduced assessment in  most of these cases could in theory trigger a downgrade, but the logic of S&P’s position is that it is those it views to have the least easily defended ‘competitive position’ whose rating is at most risk . Counter-intuitive though it might seem at first sight, those therefore with ‘only’ a strong ‘competitive position’ assessment seem most exposed.

Moreover the assessments for the capital adequacy part of the analysis (known as the ‘financial risk profile’ score) also reflect prospective earnings so a more bearish view of ‘competitive position’ leading to worsening prospective earnings can impact this part of the analysis too, magnifying  the ratings impact.

It should be noted however that S&P also stresses a general concern about pricing discipline and, ultimately, a general willingness to under-price by any of the 23 groups undermines perceived competitive strength in a rating analysis.  And since it is not 2013 and prior performance that S&P is concerned about, up-coming releases of 2013 numbers may not provide much of a guide either (though any performance that is  materially ‘below peers’ would certainly not help a group’s case).

For S&P rated reinsurers now more than ever defending their rating will require effectively communicating both exactly what their competitive advantages are (the ‘why’ not just the ‘what’), persuasively arguing that they will not be market share focussed, and that their risk and pricing controls are robust across all operations .  And then hope it’s a reasonably benign cat. year and that their prior year reserves are adequate!

Stuart Shipperlee, Analytical Partner, Litmus Analysis

Lloyd’s on the cusp of ‘AA’ range ratings; this could be a game-changer

During the summer both A.M. Best and Fitch assigned ‘positive’ outlooks to their current Lloyd’s market ratings. S&P did so last year.

Translating the A.M. Best rating scale to the one used by S&P and Fitch this means that Lloyd’s is rated ‘A+’ with a positive outlook by all three agencies.

While a subsequent upgrade from any one agency is not a given this suggests (absent a – truly – major loss) that a ‘AA’ range rating from one or more of the agencies is very likely in the not too distant future.

This would be both a notable step in the long-run post R&R transformation of Lloyd’s and also a profound event for the global reinsurance and specialty lines sector.

If the latter point seems like hype, consider this; only eight of the largest 40 reinsurance groups in the world have a major reinsurance carrier rated in the ‘AA’ range by S&P*. Lloyd’s paper would be rated equivalent, or close, to the strongest globally available from professional reinsurers. Yet organisations can transact business via Lloyd’s who could never begin to achieve that rating level independently.

Writing at Lloyd’s for any re/insurance group with an ability to also write via its own carriers is often seen as a ‘trade-off’. The market costs and Franchise Board oversight are seen (by some at least) as negatives, while the licences, (potential) capital efficiencies, distribution and brand are positives. The current rating is an important positive for many – but not all – and not so much that it is the overwhelming factor for much of the market’s capacity.

BUT, if the decision to trade at Lloyd’s also means the ability  to offer ‘AA-‘ paper then it becomes a whole new ball game.

Even very well known ‘A’ or ‘A+’ rated groups (for their non-Lloyd’s carriers) that are active at the market might now say “of-course we can offer you ‘AA-‘ paper via our Lloyd’s platform if you prefer”. We could even finally see some true ‘credit risk’ based pricing spreads emerge. And those not active at the market would be faced with a very different ‘cost/benefit’ scenario about whether to pursue participation.

Of course, we should not confuse this with the idea that a rating is, per se, the only way re/insurers, brokers, or buyers should communicate or evaluate financial strength. At Litmus we have long argued that a balanced set of inputs should be considered. Nonetheless, there’s no avoiding the fact that a ‘AA-‘ rating in the reinsurance market is a very powerful card.

How Lloyd’s might react to any flood of participation interest is itself an issue. The rating agencies have heavily bought into the ‘selectivity’ and oversight of the Franchise Board in getting to the current rating levels (along with the demonstrated robustness of the ‘market level’ capital model). So, from both a ‘market’ and a ‘ratings protection’ perspective the Franchise Board is likely to be very cautious about any ‘upgrade driven’ participation interest.

Nonetheless the market wants risk spread in the world’s growth economies and what better way to get it than by being able to say ‘if you meet our standards you can offer ‘AA-‘ paper to your clients’; a rating level higher than that of the sovereign in most of those markets.

* Source: S&P’s Global Reinsurance Highlights 2013

Stuart Shipperlee, Analytical Partner

Lloyd’s, Aon, the Berkshire ‘side car’ and the history of the London Market; what really is the strategic concern?

The late ‘80’s was a very particular time and place in the City of London. ‘Big Bang’ and the Lawson boom set the tone for the UK’s financial centre’s own version of American Yuppiedom.  Mobile phones the size of bricks, red braces, big hair, cocktails of dubious provenance, ‘Swing Out Sister’ (that’s a band!) and in the London insurance market the LMX spiral; in all its self-regarding and self-indulgent pomp.

The brief period of the highs then lows of the LMX market sometimes detracts from the recollection of a wider truth; that London had long been a ‘subscription’ market before ‘excess of loss’ reinsurance came to the fore. Indeed co-insurance meaningfully existed in London well before reinsurance really did anywhere. One could argue that London exists as an insurance centre in no small part because of its history as a subscription market with its ‘lead and follow’ underwriting culture.

At the time of LMX’s late ‘80’s hay-day your correspondent was a 20-something analyst at a small insurance data and ratings business called ISI (then owned by the stockbrokers FPK). It’s impossible not to recall that much of what I was analysing did seem to be a bizarre blend of ‘churn’ and hubris. No doubt that was, at least in part, the arrogance of (my) youth but, as we got into the ‘90’s and things started to unravel, my prejudices were, if anything, reinforced.

I therefore always enjoyed meeting intelligent and informed cynics of that world. One was an American working in London at Bankers Trust. I recall he saw the opportunities for how capital could be successfully deployed through London’s ability to attract risk and profitably distribute it via the syndication of capital, but was just perplexed by the way the market actually worked. 

His name was Tom Bolt.

At that point Tom was looking to develop BT’s insurance derivatives business but if we recall that the young (or youngish) talent in the ‘traditional’ market at that time included (to name just a few) Stephen Catlin, John Charman, Tony Taylor, and Chris O’Kane (founding CEO’s of four of today’s top 40 global reinsurers) the reality of the market’s intellectual bedrock is clear.

The problems were partly the frictional cost of the then LMX spiral in general and the tiny percentages on line slips in the following market (all seemingly requiring a lot of ‘lunching’ by brokers), and the equally miniscule capital bases of many of them. But especially the lack of discrimination in risk pricing that came along with the following market. ‘What if the “lead” was wrong?’ was not a high priority question for a lot of that ‘innocent’ capacity?

Fast forward to 2013. Tom is, of course, Performance Director of the Lloyd’s Franchise Board (LFB); a  body whose basic raison d’etre derives from the lessons learned in requiring that the ‘lead’ does indeed need to know what he or she is doing. The competitive advantage of London’s insurance market remains its unique collective intellectual property, innovation and global connectivity (we might call it a ‘cluster’) and the ability to syndicate capital.

So, Messrs Buffet and Jain decide they would now like to be part of London’s 2013 ‘following’ market. In stark contrast to the history above they offer very large scale capacity and the highest levels of security available.  They are anything other than innocent capacity.  Any incremental frictional cost appears tiny (at least as far as we can see) and the ‘lead’ is controlled by the discipline of the LFB.

That is simply a massive endorsement of what Lloyd’s has become. This seems a strategic threat only if you believe that London’s strengths actually don’t matter. And, if you do believe that, the game’s up anyway. Capital is a very fluid commodity; it has no need to be ‘located’ in London. So, if a large and very highly informed slug of it chooses to endorse underwriting decisions made at Lloyd’s, then that’s great, surely?

Naturally there is the concern that some market participants get ‘written down’ to accommodate the Berkshire behemoth, but ultimately Lloyd’s wants underwriting led market participants offering a globally diverse risk exposure in speciality lines, and especially more exposure to the world’s growth economies. If some market capacity in the existing business gets freed up by Berkshire’s supporting balance sheet then, fundamentally, that helps Lloyd’s and its underwriting leaders and innovators drive the market forward doesn’t it?

Stuart Shipperlee, Analytical Partner, Litmus Analysis